Bad Trades, Except in Korea

Published 11:27 AM ET Fri, 3 April 2009
Updated 11:57 AM ET Thu, 5 Aug 2010
The New York Times

The big banks made a lot of bad trades that cost them billions of dollars. Now they may lose money on the good trades they made.

That possibility arises from a fundamental tenet of international law that is not written down in any law book: In extremis, the locals win.

The International Swaps and Derivatives Association, a trade group representing banks that sell products whose public image these days rivals that of lead paint and asbestos insulation, is upset by court rulings in South Korea that are allowing companies to escape, at least temporarily, from disastrously bad trades in currency contracts known by the lovely nickname of Kiko.

“The court has set undesirable legal precedents that harm not only the derivatives industry in Korea, but also the country’s financial stability as a whole in the longer term,” said Keith Noyes, the association’s regional director for Asia.

The term Kiko is short for knock in-knock out currency options contracts. The “knock out” part of the name seems apt, at least in the boxing sense. There have been a number of corporate bankruptcies, and more are expected if the banks prevail in court.

Korean and international banks promoted this product as a way for Korean exporters to offset the risks of having the Korean won rise in value against the dollar or other currencies. Such an increase was bad from the point of view of the exporter, since it would mean the dollars received would not go as far as expected to cover the local costs of production.

Such protection is easy to receive without using exotic derivatives, but at a cost. The banks told companies they had a way to minimize the cost, and a lot of companies were persuaded.

That product combined a “knock-in” option that would take effect only if there were a big move in currency prices, and a “knock-out” option that would vanish if that big move took place. The companies bought call options, allowing them to buy the won cheaply, but gave up the right to buy won if the won fell too far. They sold put options, which would force them to buy won, but only if the currency took a big fall.

To make the derivatives even cheaper up front — and more risky in the long run — companies often sold two or three times as many put options as they bought call options.

If that sounds confusing, don’t worry. A lot of the customers seem to have been confused as well.

What it meant was that if the won rose against the dollar, or even held more or less steady, the Korean companies would get a break on foreign exchange costs. But they paid for that break by risking huge losses if the won collapsed.

In 2006 and 2007, when these contracts were being sold, the dollar was steadily falling against most Asian currencies, including the won, and that was the risk companies were worried about. In 2008 and into this year, the won collapsed, going from under 1,000 to the dollar to more than 1,500 at the peak early last month. The lawsuits began to fly, adding up to more than 330 at last count.

The Korean courts have so far blocked enforcement of nine contracts, pending trials. In the major decision earlier this year, the Seoul Central District Court justified its decision on the kind of logic that would apply in the United States to a lawsuit involving an unsophisticated individual investor and a fast-taking broker. The court pointed to questions of whether the contract was a suitable investment for the company, and to whether the risks were fully disclosed.

The judgment also referred to the legal concept of “changed circumstances,” concluding that the parties had expected the exchange rate to remain stable, that the change in circumstances was unforeseeable and that the losses would be too great for the company to bear.

Such logic is abhorrent to the banks. They view the transactions as trades between two sophisticated parties that are assumed to understand and accept the risks involved. A suitability analysis, or a changed circumstances defense, should have no place in such a world.

“The court is allowing parties that get their investment strategies wrong to sue for damages,” Mr. Noyes said.

An executive of one company that prevailed in the first round said in an interview that the banks lured companies into buying Kikos without fully explaining the risk. He asked that his company’s name not be used because the court case is continuing.

The banks have won a couple of cases, but even there they are not happy. That is because the decisions were based on conclusions that the banks had met their duty to provide advice on how the customers could close the contracts and keep the losses from growing. The banks think they had no such duty.

There are two problems with the banks’ arguments, even if they are legally sound. First, they do not represent the reality on the ground, where customers think the bankers are selling them products they may need, not just trading with them.

The second is even more important. When the locals feel like the out-of-towners have taken advantage of them, they are likely to gain sympathy from local judges, particularly if the losses are far greater than the locals can afford to pay.

These disputes are reminiscent of suits in 1994 between Bankers Trust and two American companies, Gibson Greetings and Procter & Gamble. The bank sold derivatives to the companies that would save them a little money if interest rates stayed level, at a cost that would rise exponentially if rates soared, as they did.

Bankers Trust had the same defense. It was not a trusted adviser, merely a trader. That defense failed, and in the end the bank was forced to settle. The publicity hurt its reputation badly, and it eventually was acquired by Deutsche Bank.

The big mistake the banks seem to have made in Korea is that they entered into contracts that could produce losses their customers could not hope to pay. They should have found a way to write a limit to losses into the contract, but that would have called attention to just how large the losses could be.

Even if the banks somehow prevail in court, they will not get all they are owed. If they lose, it becomes one more mess that taxpayers will get to clean up.